Reinharts: US Fully Deserves a Credit Downgrade

♠ Posted by Emmanuel in , at 8/03/2011 12:01:00 AM
It's good to know that those who've studied troubled economies largely echo points I raised in my recent post on the US budget deal to raise the debt ceiling. Carmen Reinhart of This Time is Different fame and her husband Vincent Reinhart at the AEI are also very lukewarm about the positive outcomes that can emerge from the deal. They ultimately argue that a downgrade is justified. Many things remain unsettled--the true magnitude of budget cuts, the political fighting between parties in the run-up to the next presidential election over identical issues, the lacklustre economic performance of America that threatens to further undermine fiscal sanity, the response of foreign creditors, and the largely unaddressed matter of long-term non-discretionary spending.

In addition to these, the Reinharts rightly point out that further unravelling of the housing-industrial complex remains an albatross around America's neck. After all, when the largest asset class of many Americans is decidedly impaired, knock-on effects on consumer spending follow. Given the strange enthusiasm for balanced budget amendments at the federal level, do not forget that many state and local governments are already resorting to accounting sleights of hand to make things appear balanced. Previously, the federal government helped keep local governments across the land afloat. Hence, the knock-on effects of the federal government being made to live within its means (or what passes for it in the depraved US context) will have negative implications down the line. It's not a pretty picture:
This week America must wait nervously to find out whether the deal will be enough to save its credit rating. The rating agencies recently laid out two important vulnerabilities that might lead them to mark it down. Given the deal does little to address either, the agencies are likely to make good on their threat to downgrade.

The first concerns the true nature of America’s overextended government, which stretches well beyond the $14,300bn public debt that is currently subject to limit. Here the federal sector is on the hook for a number of liabilities. Some are well known, and based on legislated promises, such as the underfunded social safety net. Others are unacknowledged, but will soon hit the national balance sheet.

In particular, unfinished business lingers from the financial crisis of 2007-09, mostly related to bad mortgages. Those are troubling for those institutions that hold the debt, as well as being a considerable burden for the one in five mortgage owners whose houses are now worth less than their debt.

This unfinished business has damaged the housing market and slowed growth, while also hitting state and local governments. Authorities splurged in the good years of the housing bubble, but did nothing to prepare for leaner times. Widespread deleveraging is thus still the order of the day. And when so many want to spend less than their incomes, an economy sputters.

This poor performance is what we should expect from history, where post-crisis economies grow more slowly, and unemployment stays high, in the decade after a major financial crisis. Economic data last week confirmed this, with the S&P/Case-Shiller home price index declining again, and gross domestic product expanding by less than 1.5 per cent over the past four quarters.
The verdict is damning on what is likely to come:
The rating agencies are not likely to be impressed by this weekend’s drama, and rightly so. Yet a downgrade would still be a shame, if only because this deal ought to open up a further opportunity for US politicians. US tax policy is shambolic and spending discipline non-existent. If Republicans could accept that the average tax rate has to rise, Democrats could perhaps appreciate that this may not be best accomplished by raising marginal tax rates in the existing system. Both could agree to discipline spending.

Such steps could arrest the steady increase of debt-to-GDP ratios, even after addressing those looming contingent liabilities. The nation would be better off. If moves are made quickly, there is much good that can now be done. But the chances are that stalemate will return, and any declarations of victory over a debt downgrade are likely to prove premature.
An honest reading is that the American situation will be grim.